Time for global investors to batten down the hatches ahead of approaching financial storm

There is an ominous sense of déjà vu about the world right now which is reminiscent of a global economy out of control and heading into a new disaster. Global growth is running out of steam, world debt exposure has reached crisis proportions, while over-leveraged financial markets are looking extremely over-stretched. A single major credit event like 2009’s Lehman’s collapse would be enough to tip the world back into deep catastrophe.

Next time, there might be no easy way back. Policymakers are running out of options on how to deal with any new crisis. Global interest rates are already down at rock bottom levels, the world is awash with synthetic money created by the central banks’ super-stimulus and government debt exposure is bursting at the seams. Short of prayers to St Jude, the patron saint of Lost Causes, the world’s policy cupboard is looking too bare to cope.

If policymakers seem to be sleepwalking into another crisis, so too are the global financial markets. Lifted by $15 trillion of central bank pump-priming over the last seven years, global equity markets seem far removed from any deep-rooted bear market tendencies. Bond yields are close to record lows, corporate credit spreads remain relatively tight, while market fear gauges like the Vix volatility index are hardly fretting. It is fair to say that global financial markets have ‘irrational exuberance’ written all over them right now.

Some global policymakers may be ranting and railing against the potential ‘doom-loop’ that the world economy is getting itself tangled up in, but little is being done to stop the rot. Supranational bodies like the International Monetary Fund, the Bank for International Settlements and the World Bank have all warned about the explosion of global debt, but talking is one thing and direct action is something else.

Their main worry is the global recovery has become too dependent on an explosive build-up of debt thanks to all the cheap money generation in the wake of the financial crash. Since 2007, world debt is estimated to have risen by $57 billion, an accumulation which could have devastating future effects if it starts to sour. Households, businesses and governments have all increased debt at a time when borrowing costs have hit an all-time low. It is less of a problem as cheap money is helping the real economy by boosting consumption, investment and growth. But the chief worry is that cheap money has mainly been ramping up financial speculation in property, stocks and high risk assets.

Once the world interest rate cycle starts to turn, this will have seismic consequences for global growth and for markets. Tighter lending conditions will drag on growth as consumer spending and business output, investment and hiring plans start to stall. Higher borrowing costs will also tighten the screws for over-leveraged investors raising the risk of more than a knee-jerk correction in markets at some stage.

Confidence is key right now. In recent years, corporate debt has reached extreme levels and far exceeds pre-Lehman levels, with companies continuing to borrow like there is no tomorrow. If market confidence collapses and equity and credit markets start to crumble, the cost of capital to businesses could rise very sharply. The increased spectre of major corporate failures or debt defaults could quickly lead to very sharp hikes in credit spreads.

This would be serious news for emerging market economies (EMEs), which have been a major crucible for world economic recovery in the wake of the global crash. During the recovery process over the last six years, EMEs have become seriously over-burdened by crippling debt levels and any new crisis of confidence could easily trigger investor capital outflows and spark a new financial storm. World growth prospects could suffer badly.

The global economy is sitting on a ticking time bomb which quickly needs defusing to avert another full blown crisis. A further troubling development is that the next potential leader of the world’s biggest economy is far from being a safe pair of hands. If Republican candidate Donald Trump is elected to be the next US President in November, the world could be in deep trouble. 

Trump’s maverick ideas to rid the US of its $19 trillion Federal debt pile by ‘discounting’ could be the beginning of the end for global financial stability.  It could trigger a savage reaction in global markets and the mother of all credit events.

It may be time for global investors to batten down the hatches against the approaching financial storm.

Euro zone’s brave new world of recovery is doomed to failure

For once, the European Central Bank has been doing the right thing. Regularly blamed for not doing enough, or being too late with policy solutions, the ECB’s monetary super-stimulus is finally paying dividends. Euro zone growth is outpacing its Group of Seven partners and the bloc’s unemployment rate has fallen dramatically. Understandably it is building hopes for sustainable recovery ahead.

Things are clearly looking up after years of economic poor health and crisis in Europe. Thanks to the first quarter’s 0.6 per cent GDP gain, the euro zone economy grew at its fastest pace in five years, driven by unlikely stars such as France and Spain. Critically the euro zone economy has risen above its pre-crisis peak, with growth surging past the US and UK.

Sadly, the euro zone’s success could easily prove to be its undoing. The more euro zone growth gets onto a stronger footing, the more it strengthens the case for Germany’s hawkish central bank (the Bundesbank) to put a future block on open-ended ECB easing. Unfortunately, the recovery still needs more careful nurturing to deal with major economic headwinds coming the euro zone’s way.

External risks and internal frictions still pose serious pitfalls for the economy. Slowing global growth, entrenched deflation pressures and deepening financial market uncertainty pose enough potential to derail the euro zone’s nascent recovery. The euro zone also needs to chart its way through dangerous political waters. Threatened exits by Britain and Greece out of the European Union could pose deeply troubling shocks to the euro zone economy up ahead.

While the recovery in growth is clearly welcomed, it is raising concerns in Germany that the ECB is going over the top with too much stimulus. Negative interest rates and vast infusions of QE money might have put the euro zone back on track to recovery, but German policymakers are worried that too lax policy will open up the floodgates to overheating and inflation risks down the line. The economy may be getting too much of a good thing.

Upcoming ECB policy meetings could see some brutal confrontation between the monetary hawks and doves. The Bundesbank are likely to press for more monetary stability with no new easing, possibly even calling for a policy taper at some stage soon. In its view, ECB policies have already made enough positive inroads. The banks are lending more and consumer demand is picking up thanks to easier access to cheap credit and stronger labour markets.

The Bundesbank’s key concern is that the euro zone has become over-dependent on the flow of easy money and the dilemma is what happens when the taps are finally shut off. Consumers, businesses and financial markets must be weaned off the steroids of super-stimulus before it is too late and the euro zone follows Japan into a similar zombie land of economic stagnation, perpetual deflation and ineffectual policymaking.

ECB doves remain adamant the central bank’s monetary accelerator must stay firmly rammed to the floor. The pro-easing camp believes the euro zone is bogged down by fiscal austerity, high debt, weak bank profits, high unemployment and too much excess capacity in the economy. While ECB President Mario Draghi might have met his pledge to do ‘whatever it takes’ to secure recovery, the argument now is about ‘how much more will it take’ to secure sustainable prosperity longer term.

Right now the omens are not encouraging. Last month the euro zone slipped back into deflation again, the euro zone’s all-important economic sentiment indicator has started to flat-line, while German business sentiment indicators are looking more lacklustre. If Germany, the euro zone’s biggest growth driver, loses much more momentum, the chances of the ECB hitting its modest 1.5 per cent growth target this year will be compromised.

As a result, ECB policy is heading towards potential deadlock. The monetary policy meeting in June could prove to be a critical High Noon for rate policy intentions with neither side looking likely to back down. It could end up in a dangerous stalemate. 

Any sign of a policy stall is unlikely to go down well with the markets. The US Federal Reserve and the Bank of England are both in ‘wait and see’ mode, while the Bank of Japan is keeping its powder dry in case of emergency. If the ECB looks in any doubt on future easing, it could catapult global risk appetite and world equity markets into a very nasty tail-spin.

Article appeared in the South China Morning Post 10th May 2016

Japan's inaction could be the last straw for global equity rally

There is a very good chance the global equity rally has finally reached the end of the road. Stock market sentiment has been at a tipping point for quite a while and last week’s shock over the Bank of Japan’s refusal for now to go any deeper into negative territory on interest rates could prove to be the last straw. Market fears about the era of central bank monetary super-stimulus coming to an end are gaining ground.

Japan has reached a policy impasse. The economy is grinding to a halt and another recession seems on the cards. Consumer demand is dead in the water, industry is riddled with gloom and the economy is stuck in deflation. Government finances are in a mess, leaving little room for further fiscal reflation. And now the Bank of Japan is throwing in the towel on further interest rate cuts, unless there is an emergency. Japan’s macroeconomic policy has just hit a brick wall.

It is no surprise that Japanese investors are taking matters into their own hands and selling stocks and buying the yen. Last week the yen posted its biggest weekly gain since 2008, bad news for exporters and an ominous portent of increasing risk aversion to come. Normally, when Japanese investors are spooked they liquidate overseas investments very quickly. Repatriation of funds back to Japan is a classic knee-jerk reaction in times of market stress.

The yen was one of the biggest beneficiaries of the global financial crisis and seems a reasonable barometer for risk appetite. What is worrying now is that the yen is rallying before any deep-seated crisis has occurred, almost in anticipation of worse to come. Stock markets need a healthy diet of good news to maintain a positive momentum, but the market mood is coming unstuck quite quickly.

For the last seven years, the global bull market has been fed by a constant flow of positive support and super-stimulus from the major central banks. Equity markets have been pumped up by zero interest rates and aggressive quantitative easing, which has generated a huge cash pile of cheap liquidity for investors to buy risk assets. Since 2009, central banks have spent $15 trillion on bond and equity purchases, creating a market dependency that will be all the more painful when it ends.

This glut of global money is providing a strong cushion for markets at the moment but as soon as the central banks enter into a more definite phase of policy normalisation the safety net will quickly disappear. Investors already seem to be scaling back their appetite for risk in anticipation. In Europe, investors already battle-scarred by euro zone uncertainties, have cut their exposures to equities back to their lowest level since the 2011-12 crisis. The trend is clearly heading lower.

There is no sense of extreme market crisis just yet, just a gradual creep towards the exits. The trouble is that there is nowhere to hide if events turn nasty. Investor holdings of safe haven government bonds and cash are close to historic highs, despite wafer thin and even negative rates of return. Investors are being driven by an overriding need to protect capital far and above the usual goal of maximising returns. Safe haven demand for yen, Swiss francs and German government debt are likely to surge as the going gets tougher.

The usual suspects are lining up to ambush the markets. Business cycle slowdown, hard landing risks in China, the danger of epic debt defaults, another euro zone crisis and deepening geo-political tensions all have the potential to wreak major damage on investor confidence and global financial stability. Perhaps the greatest risk of all is the central banks not coming to the rescue any more.

Right now, it looks like the US Federal Reserve, the Bank of Japan and the Bank of England are done and dusted with easing. Even the possibility of additional European Central Bank stimulus looks more remote now that euro zone growth has had a 0.6 per cent GDP surge in the first quarter. However tenuous the recovery, ECB hawks have their excuse to dig their heels in.

If the central banks do come in again with additional easing, the markets will know it will be for crisis management reasons. And as soon as the BOJ hits the panic button to lower rates again, financial markets will have added proof that the global equity rally has finally hit the buffers.

Article appeared in the South China Morning Post 3rd May 2016